Why OPEC Will Cut Production

Summary

OPEC has had a difficult time recently with oil prices falling to lows not seen in more than a decade.

American oil producers have felt the damage and OPEC should understand that by now.

I recommend opening an investment in the industry by looking at oil ETFs or solar stocks.

Introduction

Every few days it seems like oil prices make some recovery based on a proposed discuss between OPEC members. With OPEC historically cutting production in the face of a drop of oil prices, the current oil crisis is commonly considered something out of the ordinary.

OPEC is definitely hurting though. The company has an impressive share of the world's production and many of its members require noticeably higher prices to balance their budgets. With the U.S. oil companies already significantly affected, it is worth knowing that never again will money be so easily available to American oil companies.

OPEC Discussion

Before we talk about what OPEC needs, it is best to start by discussion OPEC overall. OPEC, known as the organization of petroleum exporting countries, is a group of oil countries that controls a significant percentage of the world's oil reserves. Together, these countries make output decisions that affect the world's supply.

The reason for OPEC's control comes from two main things. The group controls 79.6% of the world's oil reserves but only 30% of the world's oil production. As a result, the company has the share of production necessary to make a difference in the global oil markets. The majority of these reserves come from Venezuela and Saudi Arabia, followed by Iran, Iraq, and Kuwait.

At the same time, OPEC's lack of decision has led to a devastating fall in oil prices. In 2007, oil prices hit a high of approximately $150 per barrel before rapidly dropping to just over $30 per barrel during the financial crisis. At this time, OPEC chose to cut production by several million barrels per day leading to a rapid recovery.

However, this crash was not caused by increasing OPEC production or decreasing world demand. Instead, it was caused by rapidly increasing American production. As a result, OPEC chose not to cut production with the goal of driving American producers from business, many of whom need oil prices more than double current prices.

OPEC Breakeven

Now that we have an overview of OPEC, let us start by talking some more about OPEC's breakeven costs.

The above image shows OPEC's breakeven costs as of Jan. 1, 2015. While Saudi Arabia looks to cut spending, it still has to keep a heavily suppressed populace happy, and the country has almost 29 million people it needs to keep happy. Many of these countries need oil prices of more than $100 per barrel to break even. Current oil prices are just under $30 per barrel.

The effect of this spending is having a noticeably strain on these companies. Saudi Arabia's net foreign assets have been dropping at almost $8 billion per month meaning the company has only 5-6 years of reserves left. While the company's Saudi Aramco IPO might raise much needed cash, it is a show of desperation that might not be best for the country.

More so, compared to other countries, Saudi Arabia has the best situation. Other countries like Libya, Venezuela, Iran, and Nigeria are in much more need of cash. Non OPEC producers such as Russia might be looking to get in the action and make a deal to cut production. A relatively minor production cut of 1-2 million barrels per day could easily push oil prices back up to $60 or more barrels per day.

Now we have a firm understanding of OPEC and the breakeven price OPEC requires, it is time to talk some more about OPEC's history of production cuts along with the country that has been doing most of the production cut heavy lifting, Saudi Arabia. In fact, most other countries have been increasing production while Saudi Arabia has had to cut production.

However, it can clearly be seen that OPEC cutting production, even during hefty production cuts has brought an eventual recovery to oil prices. Despite this, the late-80s, and 90s bear market in oil was very significant with major price cuts not causing a recovery in prices. Should the same situation occur, the countries of OPEC will be without production and earnings.

OPEC Production Cut

So far, we have established an overview of OPEC, the countries breakeven price, and the company's history. So now to talk about the reasons for a production cut.

First, the company's goal of managing American production has been accomplished. Companies that once had multi-billion dollar market caps and enormous followings are now on the verge of bankruptcy. Companies like Linn Energy (NASDAQ:LINE), Breitburn Energy Partners (NASDAQ:BBEP), and Seadrill (NYSE:SDRL) are close to bankrupt.

More so, unlike last year at this time, it is no longer the small oil producers with high leverages feeling the pain. ConocoPhillips (NYSE:COP) has had to do what was once the unthinkable for a major and cut its dividend. Many would agree that should the current pricing environment continue for much longer, the long loved dividend aristocrat Chevron (NYSE:CVX) might be forced to lose its aristocrat status.

In fact, the crash has been so tough and so fast that banking stocks like Bank of America (NYSE:BAC) have seen their share prices fall on fears that their exposure to energy loans will cost them dearly. This is to the energy industry what 2008 was to the financial industry. These companies have learned that crashes can hit hard and fast and will be more careful about major projects in the future.

More importantly, the highly leveraged American producers that caused production from shale, fracking, and other discoveries to rise so hard so fast will never again find money so easily available. Instead, they will be forced to grow at a reasonable rate off of their own earnings.

Now that OPEC has gotten its message across, it is time to pay attention to its own members that are hurting. The cartel does not even need to bring prices back to $100+ a barrel like they were previously, a recovery to $70 per barrel would be a blessing to their checkbooks without resulting in a substantial ramp up of American oil.

For those interested in investing, I would only recommend entering if you are here for the long term. For now, I would recommend investing in broad energy ETFs unlike to be affected by the bankruptcy of any one company along with investments in solar.

Solar utility costs are down to less than $0.05 / kWh, now competitive with many other forms of energy and as climate change becomes a bigger deal, solar will see burgeoning investment. More so, solar has been irrationally tied to oil despite the fact that many have not seen their electricity costs decrease from the current crisis making solar, still, a viable alternative.

Conclusion

OPEC despite its enormous currency reserves has been facing the same pain felt by every other oil producer. The fact that Chevron or Exxon Mobil (NYSE:XOM) doesn't have the $750 billion Saudi Arabia does to cover its costs doesn't mean that Saudi Arabia isn't feeling the effects just as hard.

Oil is expected to recover for the long haul, no one thinks that five years from now, oil prices will still be $30 per barrel. In fact those who invest now, if they can figure out where to invest, will be able to make a solid return.

For long-term investors, I recommend looking at solar. Despite a minimal earnings correlation with oil, many solar stocks are near their all time lows since the start of the crash. As a result, these stocks will see an impressive recover when oil recovers.

Disclosure:I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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